Net Present Value and Other Investment Criteria

McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

99Net Present Value

and Other Investment Criteria

Key Concepts and SkillsKey Concepts and Skills

Be able to compute payback and discounted payback and understand their shortcomings

Understand accounting rates of return and their shortcomings

Be able to compute the internal rate of return and understand its strengths and weaknesses

Be able to compute the net present value and understand why it is the best decision criterion

Chapter OutlineChapter Outline

Net Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting

Good Decision CriteriaGood Decision Criteria

We need to ask ourselves the following questions when evaluating capital budgeting decision rules Does the decision rule adjust for the time

value of money? Does the decision rule adjust for risk? Does the decision rule provide information

on whether we are creating value for the firm?

Project Example InformationProject Example Information

You are looking at a new project and you have estimated the following cash flows: Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000

Your required return for assets of this risk is 12%.

Net Present ValueNet Present Value

The difference between the market value of a project and its cost

How much value is created from undertaking an investment? The first step is to estimate the expected future

cash flows. The second step is to estimate the required

return for projects of this risk level. The third step is to find the present value of the

cash flows and subtract the initial investment.

NPV – Decision RuleNPV – Decision Rule

If the NPV is positive, accept the project

A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

Computing NPV for the ProjectComputing NPV for the Project

Using the formulas: NPV = 63,120/(1.12) + 70,800/(1.12)2 +

91,080/(1.12)3 – 165,000 = 12,627.42

Using the calculator: CF0 = -165,000; C01 = 63,120; F01 = 1; C02

= 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.41

Do we accept or reject the project?

Decision Criteria Test - NPVDecision Criteria Test - NPV

Does the NPV rule account for the time value of money?

Does the NPV rule account for the risk of the cash flows?

Does the NPV rule provide an indication about the increase in value?

Should we consider the NPV rule for our primary decision rule?

Calculating NPVs with a Calculating NPVs with a SpreadsheetSpreadsheet

Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well.

Using the NPV function The first component is the required return

entered as a decimal The second component is the range of cash

flows beginning with year 1 Subtract the initial investment after

computing the NPV

Payback PeriodPayback Period

How long does it take to get the initial cost back in a nominal sense?

Computation Estimate the cash flows Subtract the future cash flows from the initial

cost until the initial investment has been recovered

Decision Rule – Accept if the payback period is less than some preset limit

Computing Payback for the Computing Payback for the ProjectProject

Assume we will accept the project if it pays back within two years. Year 1: 165,000 – 63,120 = 101,880 still to

recover Year 2: 101,880 – 70,800 = 31,080 still to

recover Year 3: 31,080 – 91,080 = -60,000 project

pays back in year 3

Do we accept or reject the project?

Decision Criteria Test - PaybackDecision Criteria Test - Payback

Does the payback rule account for the time value of money?

Does the payback rule account for the risk of the cash flows?

Does the payback rule provide an indication about the increase in value?

Should we consider the payback rule for our primary decision rule?

Advantages and Disadvantages of Advantages and Disadvantages of PaybackPayback

Advantages Easy to understand Adjusts for

uncertainty of later cash flows

Biased toward liquidity

Disadvantages Ignores the time value

of money Requires an arbitrary

cutoff point Ignores cash flows

beyond the cutoff date Biased against long-

term projects, such as research and development, and new projects

Discounted Payback PeriodDiscounted Payback Period

Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis

Compare to a specified required period Decision Rule - Accept the project if it

pays back on a discounted basis within the specified time

Computing Discounted Payback for Computing Discounted Payback for the Projectthe Project

Assume we will accept the project if it pays back on a discounted basis in 2 years.

Compute the PV for each cash flow and determine the payback period using discounted cash flows Year 1: 165,000 – 63,120/1.121 = 108,643 Year 2: 108,643 – 70,800/1.122 = 52,202 Year 3: 52,202 – 91,080/1.123 = -12,627 project pays

back in year 3 Do we accept or reject the project?

Decision Criteria Test – Discounted Decision Criteria Test – Discounted PaybackPayback

Does the discounted payback rule account for the time value of money?

Does the discounted payback rule account for the risk of the cash flows?

Does the discounted payback rule provide an indication about the increase in value?

Should we consider the discounted payback rule for our primary decision rule?

Advantages and Disadvantages of Advantages and Disadvantages of Discounted PaybackDiscounted Payback

Advantages Includes time value of

money Easy to understand Does not accept

negative estimated NPV investments when all future cash flows are positive

Biased towards liquidity

Disadvantages May reject positive

NPV investments Requires an arbitrary

cutoff point Ignores cash flows

beyond the cutoff point Biased against long-

term projects, such as R&D and new products

Average Accounting ReturnAverage Accounting Return

There are many different definitions for average accounting return

The one used in the book is: Average net income / average book value Note that the average book value depends on

how the asset is depreciated.

Need to have a target cutoff rate Decision Rule: Accept the project if the

AAR is greater than a preset rate.

Computing AAR for the ProjectComputing AAR for the Project

Assume we require an average accounting return of 25%

Average Net Income: (13,620 + 3,300 + 29,100) / 3 = 15,340

AAR = 15,340 / 72,000 = .213 = 21.3%

Do we accept or reject the project?

Decision Criteria Test - AARDecision Criteria Test - AAR

Does the AAR rule account for the time value of money?

Does the AAR rule account for the risk of the cash flows?

Does the AAR rule provide an indication about the increase in value?

Should we consider the AAR rule for our primary decision rule?

Advantages and Disadvantages of Advantages and Disadvantages of AARAAR

Advantages Easy to calculate Needed information

will usually be available

Disadvantages Not a true rate of

return; time value of money is ignored

Uses an arbitrary benchmark cutoff rate

Based on accounting net income and book values, not cash flows and market values

Internal Rate of ReturnInternal Rate of Return

This is the most important alternative to NPV

It is often used in practice and is intuitively appealing

It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

IRR – Definition and Decision IRR – Definition and Decision RuleRule

Definition: IRR is the return that makes the NPV = 0

Decision Rule: Accept the project if the IRR is greater than the required return

Computing IRR for the ProjectComputing IRR for the Project

If you do not have a financial calculator, then this becomes a trial and error process

Calculator Enter the cash flows as you did with NPV Press IRR and then CPT IRR = 16.13% > 12% required return

Do we accept or reject the project?

NPV Profile for the ProjectNPV Profile for the Project

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

Discount Rate

NP

V

IRR = 16.13%

Decision Criteria Test - IRRDecision Criteria Test - IRR

Does the IRR rule account for the time value of money?

Does the IRR rule account for the risk of the cash flows?

Does the IRR rule provide an indication about the increase in value?

Should we consider the IRR rule for our primary decision criteria?

Advantages of IRRAdvantages of IRR

Knowing a return is intuitively appealing It is a simple way to communicate the

value of a project to someone who doesn’t know all the estimation details

If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task

Summary of Decisions for the Summary of Decisions for the ProjectProject

SummaryNet Present Value Accept

Payback Period Reject

Discounted Payback Period

Reject

Average Accounting Return

Reject

Internal Rate of Return Accept

Calculating IRRs With A Calculating IRRs With A SpreadsheetSpreadsheet

You start with the cash flows the same as you did for the NPV

You use the IRR function You first enter your range of cash flows,

beginning with the initial cash flow You can enter a guess, but it is not necessary The default format is a whole percent – you

will normally want to increase the decimal places to at least two

NPV vs. IRRNPV vs. IRR

NPV and IRR will generally give us the same decision

Exceptions Non-conventional cash flows – cash

flow signs change more than once Mutually exclusive projects

Initial investments are substantially different Timing of cash flows is substantially different

IRR and Non-conventional Cash IRR and Non-conventional Cash FlowsFlows

When the cash flows change sign more than once, there is more than one IRR

When you solve for IRR you are solving for the root of an equation and when you cross the x-axis more than once, there will be more than one return that solves the equation

If you have more than one IRR, which one do you use to make your decision?

Another Example – Non-Another Example – Non-conventional Cash Flowsconventional Cash Flows

Suppose an investment will cost $90,000 initially and will generate the following cash flows: Year 1: 132,000 Year 2: 100,000 Year 3: -150,000

The required return is 15%. Should we accept or reject the project?

NPV ProfileNPV Profile

($10,000.00)

($8,000.00)

($6,000.00)

($4,000.00)

($2,000.00)

$0.00

$2,000.00

$4,000.00

0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55

Discount Rate

NP

V

IRR = 10.11% and 42.66%

Summary of Decision RulesSummary of Decision Rules

The NPV is positive at a required return of 15%, so you should Accept

If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject

You need to recognize that there are non-conventional cash flows and look at the NPV profile

IRR and Mutually Exclusive IRR and Mutually Exclusive ProjectsProjects

Mutually exclusive projects If you choose one, you can’t choose the other Example: You can choose to attend graduate school

at either Harvard or Stanford, but not both

Intuitively you would use the following decision rules: NPV – choose the project with the higher NPV IRR – choose the project with the higher IRR

Example With Mutually Exclusive Example With Mutually Exclusive ProjectsProjects

Period Project A

Project B

0 -500 -400

1 325 325

2 325 200

IRR 19.43%

22.17%

NPV 64.05 60.74

The required return for both projects is 10%.

Which project should you accept and why?

NPV ProfilesNPV Profiles

($40.00)

($20.00)

$0.00

$20.00

$40.00

$60.00

$80.00

$100.00

$120.00

$140.00

$160.00

0 0.05 0.1 0.15 0.2 0.25 0.3

Discount Rate

NP

V AB

IRR for A = 19.43%

IRR for B = 22.17%

Crossover Point = 11.8%

Conflicts Between NPV and IRRConflicts Between NPV and IRR

NPV directly measures the increase in value to the firm

Whenever there is a conflict between NPV and another decision rule, you should always use NPV

IRR is unreliable in the following situations Non-conventional cash flows Mutually exclusive projects

Profitability IndexProfitability Index

Measures the benefit per unit cost, based on the time value of money

A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value

This measure can be very useful in situations in which we have limited capital

Advantages and Disadvantages of Advantages and Disadvantages of Profitability IndexProfitability Index

Advantages Closely related to

NPV, generally leading to identical decisions

Easy to understand and communicate

May be useful when available investment funds are limited

Disadvantages May lead to incorrect

decisions in comparisons of mutually exclusive investments

Capital Budgeting In PracticeCapital Budgeting In Practice

We should consider several investment criteria when making decisions

NPV and IRR are the most commonly used primary investment criteria

Payback is a commonly used secondary investment criteria

Summary – Discounted Cash Flow CriteriaSummary – Discounted Cash Flow Criteria Net present value

Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion

Internal rate of return Discount rate that makes NPV = 0 Take the project if the IRR is greater than the required return Same decision as NPV with conventional cash flows IRR is unreliable with non-conventional cash flows or mutually exclusive

projects Profitability Index

Benefit-cost ratio Take investment if PI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationing

Summary – Payback CriteriaSummary – Payback Criteria

Payback period Length of time until initial investment is recovered Take the project if it pays back within some specified

period Doesn’t account for time value of money and there is an

arbitrary cutoff period

Discounted payback period Length of time until initial investment is recovered on a

discounted basis Take the project if it pays back in some specified period There is an arbitrary cutoff period

Summary – Accounting CriterionSummary – Accounting Criterion

Average Accounting Return Measure of accounting profit relative to

book value Similar to return on assets measure Take the investment if the AAR

exceeds some specified return level Serious problems and should not be

used

Quick QuizQuick Quiz

Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and required payback is 4 years. What is the payback period? What is the discounted payback period? What is the NPV? What is the IRR? Should we accept the project?

What decision rule should be the primary decision method?

When is the IRR rule unreliable?

McGraw-Hill/IrwinMcGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

99End of Chapter

Comprehensive ProblemComprehensive Problem

An investment project has the following cash flows: CF0 = -1,000,000; C01 – C08 = 200,000 each

If the required rate of return is 12%, what decision should be made using NPV?

How would the IRR decision rule be used for this project, and what decision would be reached?

How are the above two decisions related?